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The High Price of Internal Inquiries

By Peter J. Henning May 6, 2011 4:51 pmMay 6, 2011 4:51 pm

The old saying that crime doesn’t pay applies especially to corporations caught up in investigations by the Justice Department and Securities and Exchange Commission for possible violations of federal law.

Just figuring out what happened to understand the potential exposure and prove to the government that a company is being cooperative means it will foot significant legal bills before any determination of a violation.

Whenever the government goes after a company for any reason, its legal fees soar. At its annual meeting on Friday, Goldman Sachs disclosed that it spent more than $700 million on lawyers in 2010, when the S.E.C. sued it for securities fraud related to the sale of a subprime mortgage investment. (Goldman also paid $550 million to settle the S.E.C. charges.)

Even before a case is filed, a company can pile up significant bills just to determine whether it will be the target of a government inquiry.

Avon Products has been the subject of an investigation since 2008 for possible violations of the Foreign Corrupt Practices Act. The inquiry began with Avon’s operation in China and has now spread to a number of other countries where its beauty products are sold, a $10 billion annual business.

According to the company’s most recent quarterly filing with the S.E.C., the investigation is looking at “travel, entertainment, gifts, use of third-party vendors and consultants and related due diligence, joint ventures and acquisitions, and payments to third-party agents and others.” That sounds like quite a bit of ground to cover.

The legal fees and costs for outside counsel conducting the internal investigation totaled $59 million in 2009 and $95 million in 2010. For the first quarter of this year, the company spent $22.5 million for the lawyers, $900,000 less than in the period a year earlier. While that drop may indicate the investigation is winding down, it does not mean Avon’s legal fees and other costs will come to an end any time soon.

The final tally for the internal investigation could easily reach $250 million, a significant expenditure for any company to bear. Once the investigative phase concludes, Avon will report its findings to the Justice Department and the S.E.C., at which point it can start to negotiate a resolution.

The government relies in large part on the violations that the company reports and usually does not conduct a separate investigation. Showing that it conducted a thorough inquiry may result in a more favorable resolution for a company, like a deferred or nonprosecution agreement that results in no criminal conviction.

That resolution still carries a potentially hefty price tag, as the government has sought ever increasing fines and civil monetary penalties for violations of the Foreign Corrupt Practices Act. In April, Johnson & Johnson paid $70 million to settle claims that it paid bribes and kickbacks to foreign doctors working for government agencies, while in January Maxwell Technologies paid $13.65 million for violations from payments to Chinese government officials to purchase its equipment.

Given the widening investigation of payments at Avon, the settlement number will likely run into the millions of dollars, depending on the amount of any corrupt payments and the benefits the company derived from them.

If that were the end of the matter, then there would be light at the end of the legal expense tunnel for Avon. Unfortunately, when a company gets caught up in a Foreign Corrupt Practices Act investigation, its legal costs can continue for years, even after a settlement with the government.

The company and its directors have been named as defendants in a number of securities fraud and shareholder derivative actions filed in federal and state courts that allege breaches of various fiduciary duties for not properly monitoring the company’s operations and securities violations for not making proper disclosure of the problems.

While these claims are rarely successful, the lawsuits still require legal counsel to litigate them, and even a settlement involving a nominal payment requires significant time by outside counsel.

Avon also disclosed in its most recent 10-Q filing that it dismissed four officers previously suspended for their roles in making payments to Chinese government officials, including its former head of global internal audit and security.

If the government decides to pursue an action against any individuals for violating the Foreign Corrupt Practices Act, something it has shown a greater inclination to do recently, these are the most likely targets of the case.

Avon’s corporate bylaws include a broad indemnification provision for any employees investigated or charged for conduct related to work on behalf of the company, so Avon will be responsible for paying their legal fees if the Justice Department or S.E.C. pursue a case.

In addition, the Avon bylaws also provide that expenses incurred “in defending a civil or criminal action or proceeding shall be paid by the corporation in advance of the final disposition of such action or proceeding,” so long as an employee who has been charged agrees to repay the company if it turns out there was no right to indemnification.

Such agreements are rarely collectible by the company because the legal fees often far outstrip what a former employee could ever repay, so Avon is unlikely to recoup the money it spends defending individuals.

The cost of litigating a Foreign Corrupt Practices Act case can be significant, as recent prosecutions of individuals have shown. The pretrial and trial proceedings often involve complex legal issues, and the underlying transactions at Avon may reach back as far as 2004, so the volume of documents that need to be reviewed will be extensive.

Legal fees could easily run into the millions of dollars for any individual defendant, all payable — at least initially — by Avon. While crime does not pay, it sure can be lucrative for law firms.